Technical analysts eye 50% retracement for S&P 500

JohnSpence

BOSTON (MarketWatch) -- Although many investors and media outlets were celebrating the Dow Jones Industrial Average breaking through the key psychological level of 10,000 on Wednesday, technical analysts seem more preoccupied with the S&P 500 poised to make a so-called 50% retracement to the index's all-time high.

The Dow
DJIA, +0.40%
briefly climbed over 10,000 -- the last time it traded above that level was in early October of 2008.

Yet traders who rely on technical analysis are focused on a different number and index. Specifically, 1,121 on the S&P 500
SPX, +0.36%
another popular benchmark to take the market's pulse.

Chart watchers have marked 1,121 for the S&P 500 as a crucial point because it represents a 50% retracement of the epic market crash that played out between October 2007 and March 2009. The 50% level is a favorite among traders because stocks have historically tended to move even higher once they clear that hurdle. Retracements of 38.2% and 61.8% are other key points, based on the Fibonacci series.

'Important level'

The 50% retracement level of 1,121 is the midpoint between the S&P 500's all-time high of 1,576 in October 2007, and the bear-market low of about 666 in early March.

Although some investors who prefer fundamental analysis scoff at chartists, "Fibonacci numbers and the technical analysis they support have long had many adherents on Wall Street," said Nicholas Colas, ConvergEx chief market strategist.

"While the basics of the discipline are rooted in centuries-old mathematics, the confusing state of the market (lackluster/poor economic data combined with robust equities markets) has increased the use of such analysis among even fundamentally minded investors," he wrote in a research note Wednesday.

In technical circles, the 50% retracement "is an important level for the S&P 500 to surpass if further bullish market action is truly in the offing."

Still, more investors are growing wary of the dramatic seven-month rally in stocks that appears to have priced in a robust economic recovery. With credit markets still impaired and job losses piling up, some say expectations are too high and that the market is perched for a correction if the news disappoints.

'Befuddling' rally

The S&P 500's rise on Wednesday pushed the index to a 60% gain since the March 9 low, one of the sharpest rallies in history.

"The U.S. equity market's advance continues to befuddle those who are waiting for a sizeable price decline before putting their money back to work," said Sam Stovall, chief investment strategist at Standard & Poor's Equity Research.

Earlier this month, S&P's investment policy committee raised its 12-month target on the S&P 500 to 1,150 from 1,100. Stocks will benefit from "an expected gradual rise in global economic growth projections, a further weakening of the U.S. dollar and the expectation of a continued improvement in corporate earnings-per-share," Stovall said in a report Tuesday.

The greenback has been under pressure lately as investors fret over the specter of inflation and government spending to combat the financial crisis.

"While we acknowledge the potential for a pullback of 5% to 10% in the coming months, due to fund managers' need to 'damn the torpedoes' as they steam toward the end-of-year finish line, we believe that an eventual pullback will likely occur from a higher price level (if at all)," Stovall wrote.

"We think the S&P 500 could maintain its upward bias during October and November, but then possibly experience some softening of prices as investors attempt to lock in gains by mid-December," he added. "A further advance is then expected in the new year as investors continue to incorporate improving global economic growth."

Fear factor

The market's fear gauge, the CBOE Volatility Index
VIX, -6.49%
has been falling recently as stocks rally. The VIX dropped nearly 20% last week for its sharpest weekly decline in more than 10 months, according to Deutsche Bank's investment strategy group.

"However, as private demand remains weak due to ongoing deleveraging, heightened unemployment, and stagnant wages, the magnitude of the [economic] recovery will considerably lag in a historical context," they warned.

Indeed, bears say the rally has been driven mainly by the government pumping liquidity into the financial system, and corporate downsizing after the credit crunch. They won't be convinced until they see meaningful improvement in top-line revenue, which will be a primary focus as third-quarter earnings season kicks off.

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